DipIFR Syllabus B. Elements of financial statements - The Lease Term - Notes ^{4 / 10}

This is important because..

The lease liability = PV of payments in the lease term!

How is the Lease Term calculated?

• Period which can't be cancelled

• + any option to extend period (if reasonably certain to take up)

• + period covered by option to terminate (if reasonably certain not to take up)

So what does "Reasonably Certain" mean?

1. Market conditions mean its favourable to do it

2. Significant leasehold improvements made

3. High costs to terminate the lease

4. The asset is very important to the lessee (or specialised/customised to the lessee)

Problem

How do we 'weight' these factors that tell us whether the lessee is reasonably certain to extend the term or not?

Eg A flagship store in a prime and much sought-after location.

Significant judgement would be needed to determine whether the prime geographical location of the store or other factors (for example termination penalties, lease hold improvements, etc.) indicate that it is reasonably certain whether or not the lessee will renew the store lease.

When is the lease term re-assessed?

It's very rare but

1. When the lessee exercises (or not) an option in a different way than previously was reasonably certain;

2. When something happens that contractually obliges the lessee to exercise an option not previously included in the determination of the lease term or

3. When something significant happens that affects whether it is reasonably certain to exercise an option. This trigger is only relevant for the lessee (and not the lessor).

Example

A 10 year lease with an option to extend for 5 years. 

Initially, the lessee is not reasonably certain that it will exercise the extension option. So the lease term is set for 10 years. 

After 5 years, they decides to sublease the building for 10 years

Answer
Entering into a sublease is a significant event and it affects the entity’s assessment of whether it is reasonably certain to exercise the extension option. 

So, the lessee must change the lease term of the head lease